Defined Interest Crediting

A New Way of Thinking: Defined Outcome as a Means to Mitigate Aversions

Defined outcome investing is an options-based strategy that allows investors to limit their risk/reward exposure to pre-set protection and return levels.

An example of a defined outcome product is one that delivers exposure to the S&P 500 on an annual basis but limits and in some case eliminated  losses and may or may not limit gains annually. In this example, the universe of potential returns has been shifted to eliminate extreme up and down markets. Numerous ranges and outcomes are available.  Shifting potential outcomes may better meet the utility and psychological needs of many investors than a direct equity investment would:

  • Better understood downside/upside potential and expected returns
  • Mitigation or even elimination of aversions – particularly loss, but risk and ambiguity as well
  • A simple path forward when the going gets tough – whether it’s an upheaval in the capital markets or individually driven, the shaped contours of such a solution better fit utility and psychological needs

This paradigm shift in consistency and outcome transparency allows for a smoother ride through capital events. Ultimately, it allows investors to increase their equity exposure through the better matching of expected outcomes to personal needs.

  • Options strategies
  • Structured notes
  • Fixed index annuities
  • Indexed Universal Life

All defined outcome solutions are built using options, which by their nature are uniquely able to introduce or eliminate exposures at particular market prices. For instance, a put option allows the owner to sell the reference security at a defined market price. As the reference security sinks in value, the put gains an equivalent amount in value.

Imagine a forward-thinking investor at the beginning of 2013 who saw a bull market long in the tooth. Such an investor might sell some or all of his equity positions, putting his assets in more “defensive” positions such as fixed income. Of course, such an investor would also risk missing continued equity growth in 2013, which is precisely what occurred.

Another path would have been for the investor to purchase a put on the S&P 500 with a strike at X% below the market, where X% is defined by the maximum point at which he is comfortable taking a hit. By the end of 2013, that investor would have participated in the substantial rally that occurred, less the cost of his downside protection.

Now imagine that same investor making a similar decision to purchase a put at the beginning of 2008. By the end of 2008, that investor would have been shielded from the significant downturn that affected equity markets that year – any drop below X% would have resulted in an equal increase of X% in his put value, effectively shielding him from harm.

Theoretically, most investors should use option strategies to:

  • protect their portfolio
  • add increased return

In practice, however, use of options introduces a high degree of complexity that most investors cannot accommodate. For instance, there are currently over a thousand different options available for sale on the S&P 500. A would-be options user needs to figure out the duration, type, and magnitude of coverage he seeks. Furthermore, depending on the protection or exposure level sought, options can be quite costly to purchase directly. Deciding how much to spend vs. the benefit derived can itself require substantial options experience. To add further complexity, the expected cost isn’t steady but varies with market expectations. For example, think of buying flood insurance on Long Island before and after Hurricane Sandy.

Despite these complexities, options are extremely popular products due to the flexibility and control they provide. In addition to being utilized directly by investors to take positions in the market, they often function behind the scenes in other financial products marketed to investors. In these packaged solutions, investors can choose the defined outcome benefits they want while leaving the options design work to product portfolio managers.

For instance, structured notes use a portfolio of options (along with the interest income of a fixed income instrument) to create a discrete strategy. A popular structured note is a so-called “buffered note” on the S&P which delivers the same performance as the S&P with a level of downside protection (and often a cap on upside potential to “pay” for the downside protection). The benefit to investors is that they can choose the investment parameters they seek (e.g., protection against the first 10% of losses) without having to directly interact with the underlying options working behind the scenes. These benefits have led to immense popularity of these pre-packaged defined outcome investments, to the tune of $2 trillion globally.

Yet, there are a number of potential drawbacks to structured notes. A structured note is an IOU of the issuer, meaning that customers do not actually own the underlying options and debt instruments. This nuance is not particularly meaningful unless the issuer cannot make good on its obligations (e.g., Lehman Brothers), in which case the difference between owning the underlying options and bonds and owning a bank-issued structured note is night and day. Drawbacks include high fees and illiquidity – it can cost hundreds of basis points to enter and exit a position. The lack of historical standardization of structured notes introduces a separate challenge to their portfolio inclusion – it is relatively difficult to compare historical structured note performance vs. other potential investments opportunities. The lack of standardization can also make it difficult to incorporate structured notes into portfolio allocations and client reporting.

Fixed indexed annuities are a type of defined outcome investment that has become popular over the last few years, especially in consideration of the low yield environment. This product mixes elements of fully principal-protected structured notes and combines them with annuity features, such as tax deferrals. The issuers are insurance companies using options to hedge exposure behind the scenes.

An Indexed Universal Life Policy is also another option that utilize defined outcome investing.  These typically have a flour, may or may not have a cap on annual growth and allow for the benefits of life insurance such as tax deferred growth and tax free access.

A traditional defined outcome solution has a term structure with a fixed beginning and end point and, as such, doesn’t lend itself to direct comparison with more traditional investments. For example, when looking to purchase a given two-year structured note vs. a low volatility fund vs. a stable REIT, it would be difficult if not impossible to see how those products would have done against each other over the last 1, 5, or 10 years, or to project how they would do against each other over the next 1, 5, or 10 years. Structured notes are one-off bank offerings for which there is typically no consistent past or future – there is no guarantee that a structured note being offered today will be available for repurchase when it matures, and there is a good chance it wasn’t available for purchase several years ago.

DIO strategies now feature the ongoing creation and redemption of exchange-traded option strategies, resulting in an “evergreen” investment not limited to a maturity date. This enables, for the first time, an ongoing defined outcome portfolio with parameters that are fairly consistent over time. These strategies are standardized, making their inclusion within portfolios and client reporting a straightforward task. In addition, the standardization enables direct comparison with other asset classes to facilitate transparent decision making.

This philosophy is to offer investors a straightforward path to defined outcomes. The benefits should be equally appealing to those who traditionally focus only on “vanilla” equity products as well as those using other defined outcome solutions such as structured notes.

Taken in total, Sage’s solutions offer investors the best of two worlds:

  • The transformative power of defined outcome investing, with its increased clarity and control of downside exposure, mitigation of aversions, and guidance during turbulent market conditions.
  • The liquidity, simplicity of access, and standardization of traditional equity products such as indexes, mutual funds, and ETFs
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